Federal Budget 2023 - Part III: Amendments to Generational Share Transfer Provisions

Canada’s latest federal budget was released on March 28, 2023 (the “Budget”). The McLennan Ross tax team is publishing a 3-part series to highlight conditions of the budget most likely to impact our clients. These consist of:

1. A summary of measures of interest to private corporations, which can be found here;
2. Employee Ownership Trusts, found here; and
3. This article addressing further changes to section 84.1 (following up on Bill C-208 which deals with transfers of shares to the next generation).

In Part III, we take a deeper dive into the new changes to section 84.1 of the Income Tax Act (the “Act”), which address the government’s concerns with Bill C-208, which was initially passed on June 29, 2021.

These changes are expected to govern sales of shares by parents to their children, nieces, nephews, grandchildren, grandnieces, and/or grandnephews (“child” or “children”) for the foreseeable future and will be critically important to any business owners who want to have their children take over their business.

Overview of Changes to Section 84.1

The enactment of Bill C-208 in 2021 was quite exciting for the tax world, as it addressed a long standing “injustice” in the Canadian tax system: that a sale of shares eligible for the capital gains exemption (the “CGE”) to an arm’s length party resulted in a better tax result than the same sale to the vendor’s children. This was because section 84.1 of the Act effectively prevented the vendor from claiming the CGE on a non-arm’s length sale.

Bill C-208, a private members’ bill which received support from all parties, aimed to address this. A summary of our previous article on Bill C-208 can be found here.

However, there were a lot of problems with Bill C-208. The Government was primarily concerned it would allow income from corporations to be extracted at extremely low rates in cases that did not actually involve the transfer of the business. Even tax practitioners were concerned that it included some very strange requirements, and did not mesh well with the rest of the Act.

The changes proposed in the Budget address the Governments concerns and some concerns of tax advisors. These amendments are proposed to apply to dispositions of shares that occur on or after January 1, 2024. In the meantime, we may continue to sell shares to children using the provisions of Bill C-208.

Summary of the New Rules – Immediate and Gradual Business Transfers

The new rules provide two possible exceptions to the CGE restriction on non-arm’s length sales: one for “immediate” business transfers and one for “gradual” business transfers. Both are addressed below.

Rules for Immediate Business Transfers

To qualify for this exception, and therefore allow the vendor the claim the CGE, the following conditions must be met at the time of the sale:

1. The shares being sold must qualify for the CGE (in other words, be qualified small business corporation shares or shares of the capital stock of a family farm or fishing corporation as defined in subsection 110.6(1)). This has not changed from Bill C-208.
2. The parents must control the corporation whose shares are being sold (the “subject corporation”). This is a new requirement which is not ideal from a taxpayer perspective since it will complicate selling shares of a corporation that the parents do not control. However, it may be possible to work around this with the use of holding corporations.
3. Immediately after the sale, the parents cannot have legal or factual control of the subject corporation, the purchaser corporation or any other person or partnership that carries on an active business relevant to determining whether the subject corporation qualifies for the CGE[1] (a “relevant group entity”). The key challenge here is the question of factual control, which is open to interpretation and so may not always be clear.[2]
4. Immediately after the sale, the parents must own less than 50% of any class of shares, other than a specified class (non-voting preferred shares with specific characteristics), of the subject corporation or any relevant group entity. Note, this does allow the parents to continue to own an unlimited number of a specified class of shares.



There are additional conditions that relate to the 3 years following the sale. In particular, during the first 3 years after the disposition:

5. The child or children must control the subject and purchaser corporation.
6. At least one of the children must be actively engaged on a regular, continuous, and substantial basis[3] in the business of the subject corporation or a relevant group entity.
7. All the businesses of the subject corporation and relevant group entities must be active businesses. This effectively means that the purchasers cannot liquidate the assets of the active business immediately after the sale and transition to investment corporations.

Additionally, after the 3 years have passed, the parents may not own any shares except for a specified class of shares. Also, by the end of the 3 years, or if it is reasonable in the circumstances a greater time, the parents must have taken reasonable steps to transfer the management of all businesses of the subject corporation and any relevant group entity to the child or children and permanently cease to manage any business of the subject corporation and any relevant group entity.

Rules for Gradual Business Transfers

The rules for gradual business transfers are the same except:

1. The immediate transfer is only required to be of legal control, not factual control. This suggests that the parents may continue to have greater involvement in the corporation, at least for 5 years (as indicated below).
2. In addition to the immediate transfer of the majority of all classes of shares except shares of a specified class, within 10 years the parents’ economic interest in the subject corporation (in the form of either debt or shares) must be equal to or less than 50% for a farm or fishing corporation and 30% for a small business corporation. This is interesting, because this requirement arguably does not need to be met with the immediate business transfers (depending on the meaning of factual control). As a result, this is an additional requirement for the gradual transfer over the immediate transfer.



Further, the conditions required to be maintained for 3 years for immediate transfers discussed above, must instead be maintained for 5 years. In particular, for 5 years:

3. The child or children must maintain control of the subject and purchaser corporations.
4. At least one child must be actively engaged in the business.
5. All the businesses of the subject corporation and relevant group entities must be active businesses.

This makes the test harder to meet and will constrain the children’s business activities for a greater period of time. However, the parents will have the benefit of 5 years to transfer management of the businesses instead of 3 years.

Other Amendments

Bill C-208 had a few strange elements that we are pleased the Budget proposes to remove. There will no longer be:

• A requirement that the vendors swear an affidavit that they disposed of the shares.
• A requirement to obtain an arm’s length valuation be obtained (though we typically recommend one to support the assigned value).
• A supposed claw back of the CGE for larger corporations. There were concerns these provisions of Bill C-208 were not even effective and they seemed unfair, since there is no limit on the CGE based on the size of the business for arm’s length sales.

Additionally, Bill C-208 failed to address some circumstances where, in the spirit of the Bill, section 84.1 should not apply to bar the CGE. The new proposals address some of these, specifically:

• The exception has now been expanded to include nieces, nephews, grandnieces, and grandnephews (instead of only children and grandchildren).
• An arm’s length sale of all the children’s interest in the relevant businesses (either in a form of the sale of the purchaser corporation, the subject corporation or the relevant entities) within the immediately following 3- or 5-year period will no longer disqualify the sale from the exemption.[4]
• A sale as a result of the death or disability of any of the children or grandchildren (or nieces, nephews or grandnieces or grandnephews) will no longer disqualify the sale from the exemption.
• The capital gains reserve is extended from 5 to 10 years. Though we note that interest may need to be charged to avoid the purchase price having a fair market value of less than its stated amount (reflecting the time value of money).



Lastly, the proposed changes include some elements which, while not necessarily helpful to taxpayers, certainly make sense:

• The vendor and purchaser must file a joint election to take advantage of the exception. This will help everyone know what is going on, including the parties and the CRA.
• The vendor and purchaser are jointly liable for the added tax if the sale does not qualify for the exemption. Purchasers may not like this change, but it may actually benefit vendors, since qualifying for the exemption depends a lot on what the purchaser does after the sale. The CRA, of course, will benefit from having more people to go after for the outstanding tax liability.
• The normal reassessment period is extended by 3 years for immediate transfers and 10 years for gradual transfers, ensuring the CRA can reassess if the post-sale conditions are not met.

Our Takeaways

The rules for the gradual transfer of the business appear to be more onerous, with the only benefit being that the parents get an additional 2 years to cease being involved in the management of the business. We suspect that in most cases it will be preferable to meet the immediate transfer test to avoid the more onerous requirements and the longer reassessment period.

Going beyond the proposed amendments to section 84.1, the changes in the alternative minimum tax (“AMT”, addressed in Part I of this series, found here) may impact the benefit of the CGE by increasing the immediate tax payable by parents. However, if the parents have lower taxable income in the years following the sale, the changes may allow them to use their AMT carry forwards more easily – though we will need to wait and see the actual legislation. In any event, when considering the option of claiming a 10-year reserve and the potential interest which would likely need to apply, it will be more important then ever to consider the impact of AMT.

Unfortunately, sales to siblings are still not eligible for the exemption. Often siblings will be in business together, then one will want to retire and sell to the remaining sibling. We think that it is consistent with the spirit of the legislation for sales to siblings to also be eligible for this exemption so would ideally like to see this further change.

Further, it is not clear whether the children would be able to reorganize the corporate structure after the initial purchase of their parent’s shares – for example by amalgamating the purchaser corporation and subject corporation or moving certain businesses to new corporations which the children still control. Until this is clarified, completing a reorganization could put the applicability of this exemption at risk.

Overall, we think these new changes are generally positive and expect that the generational transfer provisions will be useful to our clients. However, there are certainly still a few improvements that could be made.

If you have any questions about whether the current or proposed legislation may be helpful on a sale, please contact a member of our tax group.